Much Ado About ‘Bail-In’ And FRDI Bill

In the early 1990s when India’s banking law was amended to bring down the 100% government’s stake in its banks to 51%, there were all-round protests and the trade unions took to the streets. The so-called crony capitalism which spoils the quality of assets of government-owned banks, leading to periodic recapitalisation of such banks, also draws flak from different quarters. But none can match the mass hysteria that is being created by the Financial Resolution and Deposit Insurance Bill (FRDI), 2017.

While the Insolvency and Bankruptcy Code deals with the corporations that have taken money from the banks but are unable to pay back, the FRDI Bill outlines how the insolvency of a financial intermediary—banks, non-banks and even insurance firms—can be tackled. The need for such a regulation stemmed from the 2008 global financial crisis which killed iconic US investment bank Lehman Brothers Holdings Inc. and brought many large financial intermediaries to their knees, forcing large-scale bailouts by governments.

The bill envisages setting up of a resolution corporation which will replace the existing Deposit Insurance and Credit Guarantee Corporation or DICGC. Established in 1978, DICGC is a Reserve Bank of India (RBI) arm that offers an insurance cover of up to Rs1 lakh to the depositors. The proposed corporation will closely monitor financial companies, classify them in accordance with their risk profiles and step in to resolve in case of a failure (this could mean taking over a financial company).

Till here, the narrative flows quite smoothly. It takes a different turn when the bill empowers the corporation to “bail-in” a failing financial company. What’s that? A “bail-in” involves rescuing a financial institution on the brink of failure by making its creditors and depositors take a loss on their holdings. It is the opposite of a “bail-out”, which involves the rescue of a financial institution by external agencies, typically governments, using taxpayers’ money. In other words, instead of the government rescuing a failing bank or any other financial intermediary by infusing capital, depositors’ funds are being proposed to be used for this purpose. So, the depositors run the risk of losing their money or facing inordinate delays in realizing the money—and that too may not be the full amount as deposits may get converted into other financial instruments such as equity or a quasi-equity.

Will the existing deposit cover of Rs1 lakh be taken away? The answer is an emphatic no. All depositors will continue to enjoy that.

There has been a demand from certain quarters that the limit should be raised. Is there any justification in such a demand? Well, since this limit was fixed 24 years ago in 1993, and inflation has substantially eroded the value of money over this period, it can definitely be looked into.

In fact, during the financial crisis in 2008, the Indian government and RBI did have rounds of discussions on raising the limit but they refrained from doing so. It was felt that raising the limit would have made depositors suspicious about the vulnerability of Indian banks which were absolutely safe, with sovereign backing. Besides, the Rs1 lakh limit covers 93% of the depositors (in number) and 30% of the deposits (in value). In other words, the masses have been covered by this limit and the 7% who keep more than Rs1 lakh in bank deposits are presumably savvy on financial matters and well aware of the efficacy of other financial assets.

One pertinent point here: the Rs1 lakh limit is for depositors in a particular bank and not for their deposits. This means, if a depositor has a savings bank account, recurring deposit and a fixed deposit in a bank, and that bank fails, the individual is entitled to Rs1 lakh (and not Rs3 lakh even if there is more than Rs1 lakh in each of the accounts)—that too inclusive of interest.

The proposed regulation will retain the insurance cover. So, what’s the problem? The uncertainty is about the money kept in banks beyond Rs1 lakh. Now, in case a bank goes for liquidation, depositors are entitled to get only Rs1 lakh. Beyond this cover, they can get money, if any, only after the liquidation proceedings are complete and the bank’s secured creditors are taken care of. A depositor is an unsecured creditor.

Does the proposed regulation dilute the depositors’ rights to money beyond Rs1 lakh (or, any other amount in case the limit is raised) which doesn’t enjoy the insurance cover? I don’t think so. The regulation also proposes to ensure proper supervision of the lending activities of a financial intermediary, classification of them based on their risk profile (low, moderate, material, imminent and critical) alerting the depositors if a financial intermediary’s health is deteriorating and a time-bound resolution process. If we consider all these, the new architecture is any day superior to a mere DICGC cover.

Typically, when RBI senses a bank failing, it does not allow the bank to collect fresh deposits and the existing depositors are not allowed to withdraw their own money. The depositors of a dozen-odd cooperative banks, which have been in losses, have not been able to get their money back after years because their functions have been frozen but the licences are not cancelled. Once the new regulation is in place, the wait will be much shorter as there will be time-bound resolution. Besides, the insurance cover will be an absolute obligation of the proposed corporation and the money will be given before a case is resolved.

Most importantly, unlike many of the developed markets, India has not seen bank failures. Some of the cooperative banks which are often a political cesspool have failed, but RBI does not allow any scheduled commercial bank to fail. Protecting the interest of the depositors has all along been the topmost priority for India’s banking regulator. In rare cases of banks going belly-up, RBI plays the role of a match-maker and gets it merged with a stronger bank, deftly and without losing time.

The strong voices against the FRDI Bill seem to be ill-informed. The government-owned banks will continue to have the backing of the sovereign and the depositors don’t have much to worry over the safety of their money. The challenge before the government and the regulator is communicating this. If the canard against the bill continues, there could be a run on some of the weaker banks; also shadow banks may lure away money from the banking system.

Finally, an unsolicited piece of advice. A bank fails primarily because of wrong lending decisions; the depositors are never ever responsible for a bank failure. Even the cooperative banks have been playing an important role in collecting deposits and creating savings habits while their loan decisions often lead to their downfall. Keeping this in mind, the new law may consider giving a greater role to depositors’ representatives on bank boards. This could assuage the misplaced fears of many.

This column first appeared in www.livemint.com

If you want to read Tamal Bandyopadhyay’s earlier columns, please log onto www.bankerstrust.in

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. His latest book, From Lehman to Demonetization: A Decade of Disruptions, Reforms and Misadventures will be released in Bengaluru on 22nd December.

His Twitter handle is @tamalbandyo.